On November 25, 2011, the IRS issued proposed
regulations (REG-109369-10) that seek to redefine
the term “limited partner” for purposes of the
passive activity rules of Sec. 469. The proposed
regulations generally seek to ensure that members of
LLCs and partners of LLPs, other than managing
members or managing partners, are treated as limited
partners. They also suggest that the IRS may have
abandoned its effort to achieve a similar result
through litigation under the existing regulations.
Accordingly, until the IRS finalizes the new
regulations, taxpayers holding interests in LLCs and
LLPs may want to revisit whether their losses may
qualify as active rather than passive.

PreviousTreatment of
Losses from an Interest in a Limited Partnership

If a taxpayer does not materially participate in a
trade or business, Sec. 469 treats the losses or
credits from it as passive. As a result, they may
generally only be used against passive income or upon
the disposition of the activity. Limited partners in
limited partnerships have an additional hurdle to
prove that they are “materially participating.” Sec.
469(h)(2) provides that “no interest in a limited
partnership as a limited partner shall be treated as
an interest with respect to which a taxpayer
materially participates,” except as otherwise provided
by regulations.

The existing regulations allow
even a limited partner to qualify by participating for
more than 500 hours, but they prohibit limited
partners from qualifying under several other tests
that are available to sole proprietors or partners
other than “limited partners.” Those alternative tests
include the ability to aggregate several partnerships
and the ability to qualify under some circumstances
with as little as 100 hours or more (see Temp. Regs.
Sec. 1.469-5T).

For taxpayers who cannot
qualify under the 500-hour test, but might qualify
under the more liberal test applicable to nonlimited
partners, this may be a good time to review whether
they “fail” the definition of a limited partner—and
thus qualify for the more liberal tests—under the
current regulations and the cases interpreting
them.

Challenges to the Material
Participation Rules

Within the past 10 years,
several cases were decided rejecting the IRS position
that members of LLCs were limited partners for
purposes of Sec. 469.

Gregg: In Gregg, 186 F. Supp.
2d 1123 (D. Or. 2000), the taxpayer was a member of an
LLC. The court stated that, because the regulations
were silent as to the treatment of LLC members, the
limited partner exception in Sec. 469(h)(2) could not
be applied to require the higher standard of
participation that applied to limited partners. The
court looked to state law to determine the nature of
Gregg’s partnership interest and concluded that state
law in Oregon distinguished limited partner status
from general partner status based on a taxpayer’s
control rather than his liability. Since the taxpayer
could control the partnership, the court treated him
as a general partner. Apparently, even the new
proposed regulations accept the premise of focusing on
control rather than limited liability under state
law.

Garnett: In Garnett, 132 T.C. 368 (2009),the taxpayers held LLP and LLC interests through
ownership in other LLCs and treated the losses as
losses from a general partnership. The Tax Court
noted that partners in LLPs or LLCs were not
automatically constrained from participating in
management and therefore should not be presumed to
lack material participation. Accordingly, the Tax
Court ruled that the taxpayers’ interests were the
equivalent of general partnership interests, not
limited partnership interests.

Thompson: In Thompson, 87 Fed. Cl. 728 (2009), the taxpayerowned 99% of an LLC directly and the remaining
1% through a wholly owned S corporation. The court
ruled that the taxpayer’s interest would best be
categorized as a general partnership interest under
Temp. Regs. Sec. 1.469-5T(e)(3)(ii). Additionally,
the court ruled that the taxpayer did not have to
prove material participation under one of the seven
Temp. Regs. Sec. 1.469-5T(a) tests because the IRS
had stipulated that, if the taxpayer did not hold a
limited partnership interest under Temp. Regs. Sec.
1.469-5T(e)(3), he could prove material
participation. The IRS issued Action on Decision
2010-02, acquiescing to the result only.

Newell: Following the precedent
that was set in Garnett, the Tax
Court in Newell, T.C. Memo. 2010-23,ruled that the taxpayer, an LLC
member, functioned as a general partner and therefore
qualified for the general partner exception under
Temp. Regs. Sec. 1.469-5T(e)(3)(ii).

Effect on Current LLCs and Limited
Partnerships

Since the proposed regulations do
not become effective until the date they are
finalized, the current law and guidance from the court
cases discussed above remain in effect and should be
considered. Of course, taxpayers should seek the
guidance of a qualified tax adviser.

EditorNotes

Mindy Tyson Cozewith is a director, Washington
National Tax in Atlanta, and Sean Fox is a director,
Washington National Tax in Washington, DC, for
McGladrey & Pullen LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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